Financial Reporting Financial Statement Analysis and Valuation 6th Edition Pdf Read Only

February. five, 2007

The Basics

If you can read a nutrition characterization or a baseball box score, you lot tin can larn to read basic financial statements. If you can follow a recipe or employ for a loan, you lot tin larn basic accounting. The nuts aren't difficult and they aren't rocket science.

This brochure is designed to help you gain a basic understanding of how to read fiscal statements. Just equally a CPR course teaches you how to perform the basics of cardiac pulmonary resuscitation, this brochure will explain how to read the basic parts of a financial statement. Information technology will not train you lot to be an accountant (just as a CPR form volition not make yous a cardiac dr.), but it should requite you the confidence to be able to await at a prepare of financial statements and make sense of them.

Allow's begin past looking at what financial statements do.

"Show me the money!"

We all remember Cuba Gooding Jr.'s immortal line from the movie Jerry Maguire, "Show me the money!" Well, that's what financial statements exercise. They prove you the money. They show you where a company's money came from, where it went, and where it is now.

There are four principal financial statements. They are: (one) residuum sheets; (2) income statements; (3) greenbacks flow statements; and (4) statements of shareholders' equity. Balance sheets show what a company owns and what it owes at a fixed point in fourth dimension. Income statements prove how much money a company made and spent over a catamenia of time. Cash flow statements show the exchange of money between a company and the outside world likewise over a period of time. The fourth financial argument, called a "statement of shareholders' equity," shows changes in the interests of the company'southward shareholders over time.

Let's look at each of the showtime three financial statements in more particular.

Balance Sheets

A remainder sheet provides detailed information about a company'due south assets, liabilities and shareholders' equity.

Assets are things that a company owns that have value. This typically ways they can either be sold or used by the company to brand products or provide services that tin be sold. Assets include physical property, such every bit plants, trucks, equipment and inventory. Information technology also includes things that tin can't be touched but nevertheless exist and take value, such as trademarks and patents. And greenbacks itself is an asset. So are investments a visitor makes.

Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new production, hire for utilise of a building, coin owed to suppliers for materials, payroll a company owes to its employees, ecology cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the time to come.

Shareholders' disinterestedness is sometimes called capital or internet worth. Information technology's the money that would be left if a visitor sold all of its avails and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHOLDERS' Equity

A company'due south assets take to equal, or "balance," the sum of its liabilities and shareholders' disinterestedness.

A company'south balance canvass is gear up upwards like the bones accounting equation shown to a higher place. On the left side of the balance sail, companies listing their avails. On the right side, they list their liabilities and shareholders' equity. Sometimes remainder sheets show assets at the top, followed by liabilities, with shareholders' equity at the bottom.

Assets are generally listed based on how speedily they will be converted into cash. Electric current avails are things a company expects to convert to cash within one yr. A good case is inventory. Most companies expect to sell their inventory for greenbacks within ane twelvemonth. Noncurrent avails are things a company does not expect to convert to cash within one year or that would take longer than one yr to sell. Noncurrent assets include fixed assets. Fixed avails are those assets used to operate the business but that are not available for auction, such as trucks, function furniture and other property.

Liabilities are more often than not listed based on their due dates. Liabilities are said to be either electric current or long-term. Current liabilities are obligations a visitor expects to pay off within the year. Long-term liabilities are obligations due more than one year away.

Shareholders' equity is the amount owners invested in the company'south stock plus or minus the company's earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends.

A balance canvass shows a snapshot of a visitor's assets, liabilities and shareholders' disinterestedness at the end of the reporting catamenia. It does non show the flows into and out of the accounts during the period.

Income Statements

An income statement is a report that shows how much revenue a company earned over a specific time period (ordinarily for a year or some portion of a yr). An income statement besides shows the costs and expenses associated with earning that revenue. The literal "lesser line" of the statement usually shows the visitor's net earnings or losses. This tells you how much the company earned or lost over the flow.

Income statements also report earnings per share (or "EPS"). This calculation tells you lot how much money shareholders would receive if the visitor decided to distribute all of the cyberspace earnings for the period. (Companies almost never distribute all of their earnings. Usually they reinvest them in the business organisation.)

To understand how income statements are prepare, think of them as a set of stairs. You offset at the top with the total amount of sales made during the accounting catamenia. Then you go down, i step at a time. At each step, you brand a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you lot acquire how much the company actually earned or lost during the accounting period. People oft phone call this "the bottom line."

At the top of the income statement is the total amount of money brought in from sales of products or services. This top line is frequently referred to every bit gross revenues or sales. It's called "gross" because expenses accept not been deducted from it still. So the number is "gross" or unrefined.

The next line is coin the company doesn't expect to collect on certain sales. This could be due, for instance, to sales discounts or trade returns.

When you decrease the returns and allowances from the gross revenues, you get in at the company's net revenues. It's called "net" because, if you can imagine a net, these revenues are left in the net later on the deductions for returns and allowances take come out.

Moving down the stairs from the net revenue line, there are several lines that represent diverse kinds of operating expenses. Although these lines tin be reported in various orders, the adjacent line later on net revenues typically shows the costs of the sales. This number tells you the amount of money the company spent to produce the goods or services it sold during the accounting menstruation.

The next line subtracts the costs of sales from the net revenues to go far at a subtotal called "gross profit" or sometimes "gross margin." It'southward considered "gross" because in that location are sure expenses that haven't been deducted from it yet.

The next section deals with operating expenses. These are expenses that go toward supporting a visitor's operations for a given period – for example, salaries of administrative personnel and costs of researching new products. Marketing expenses are another instance. Operating expenses are different from "costs of sales," which were deducted above, considering operating expenses cannot be linked directly to the production of the products or services beingness sold.

Depreciation is also deducted from gross profit. Depreciation takes into account the wear and tear on some assets, such as machinery, tools and furniture, which are used over the long term. Companies spread the cost of these assets over the periods they are used. This process of spreading these costs is chosen depreciation or acquittal. The "charge" for using these assets during the period is a fraction of the original cost of the assets.

Afterward all operating expenses are deducted from gross profit, you lot get in at operating profit earlier interest and income tax expenses. This is ofttimes chosen "income from operations."

Side by side companies must account for interest income and interest expense. Involvement income is the money companies make from keeping their greenbacks in involvement-bearing savings accounts, coin market funds and the similar. On the other hand, involvement expense is the coin companies paid in interest for coin they borrow. Some income statements bear witness interest income and involvement expense separately. Some income statements combine the two numbers. The involvement income and expense are so added or subtracted from the operating profits to get in at operating profit earlier income tax.

Finally, income tax is deducted and you lot arrive at the bottom line: net turn a profit or net losses. (Net turn a profit is likewise called cyberspace income or net earnings.) This tells y'all how much the visitor actually earned or lost during the accounting flow. Did the company make a profit or did it lose money?

Earnings Per Share or EPS

Most income statements include a adding of earnings per share or EPS. This adding tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period.

To calculate EPS, you lot take the full net income and divide it by the number of outstanding shares of the company.

Cash Flow Statements

Greenbacks flow statements study a company's inflows and outflows of cash. This is of import because a visitor needs to have enough cash on manus to pay its expenses and purchase assets. While an income statement can tell you whether a visitor fabricated a profit, a cash flow statement can tell y'all whether the visitor generated greenbacks.

A cash menstruation statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company's balance canvas and income statement.

The bottom line of the greenbacks flow statement shows the internet increment or subtract in cash for the catamenia. Generally, greenbacks period statements are divided into three main parts. Each office reviews the cash catamenia from one of three types of activities: (ane) operating activities; (2) investing activities; and (3) financing activities.

Operating Activities

The first office of a cash menstruation statement analyzes a company'southward cash menstruation from net income or losses. For nigh companies, this department of the cash catamenia argument reconciles the net income (every bit shown on the income statement) to the actual cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items (such as adding dorsum depreciation expenses) and adjusts for any greenbacks that was used or provided by other operating assets and liabilities.

Investing Activities

The second part of a cash catamenia statement shows the greenbacks period from all investing activities, which mostly include purchases or sales of long-term assets, such as property, constitute and equipment, as well as investment securities. If a company buys a piece of mechanism, the greenbacks menstruum statement would reflect this activeness as a cash outflow from investing activities because it used cash. If the visitor decided to sell off some investments from an investment portfolio, the gain from the sales would show upwardly as a cash inflow from investing activities because it provided greenbacks.

Financing Activities

The third role of a cash flow statement shows the cash flow from all financing activities. Typical sources of cash flow include cash raised by selling stocks and bonds or borrowing from banks. Also, paying back a bank loan would show up as a use of cash flow.

Read the Footnotes

A horse called "Read The Footnotes" ran in the 2004 Kentucky Derby. He finished seventh, only if he had won, it would take been a victory for financial literacy proponents everywhere. It's so important to read the footnotes. The footnotes to financial statements are packed with data. Here are some of the highlights:

• Significant accounting policies and practices – Companies are required to disembalm the bookkeeping policies that are most important to the portrayal of the visitor's financial condition and results. These oft require management'due south virtually difficult, subjective or complex judgments.


• Income taxes – The footnotes provide detailed information well-nigh the visitor's current and deferred income taxes. The information is broken down by level – federal, country, local and/or foreign, and the master items that bear on the visitor's effective tax charge per unit are described.


• Pension plans and other retirement programs – The footnotes discuss the company's pension plans and other retirement or postal service-employment do good programs. The notes comprise specific data about the avails and costs of these programs, and indicate whether and by how much the plans are over- or nether-funded.


• Stock options – The notes also contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the issue of the method on reported results.

Read the Physician&A

You can find a narrative explanation of a company's financial performance in a section of the quarterly or annual report entitled, "Management's Word and Analysis of Financial Condition and Results of Operations." Dr.&A is management's opportunity to provide investors with its view of the financial operation and status of the company. It'due south direction's opportunity to tell investors what the financial statements show and do not show, likewise equally important trends and risks that take shaped the by or are reasonably likely to shape the company's hereafter.

The SEC'south rules governing MD&A require disclosure most trends, events or uncertainties known to direction that would have a material impact on reported fiscal information. The purpose of Doc&A is to provide investors with data that the company's management believes to be necessary to an agreement of its fiscal condition, changes in financial condition and results of operations. It is intended to help investors to see the visitor through the eyes of management. Information technology is as well intended to provide context for the financial statements and data about the company's earnings and cash flows.

Financial Statement Ratios and Calculations

You've probably heard people banter effectually phrases like "P/E ratio," "current ratio" and "operating margin." But what do these terms mean and why don't they show up on financial statements? Listed beneath are merely some of the many ratios that investors calculate from information on financial statements and then use to evaluate a company. As a general rule, desirable ratios vary past industry.

If a company has a debt-to-equity ratio of two to 1, it means that the company has 2 dollars of debt to every one dollar shareholders invest in the company. In other words, the visitor is taking on debt at twice the rate that its owners are investing in the company.

Inventory Turnover Ratio = Toll of Sales / Boilerplate Inventory for the Period

If a company has an inventory turnover ratio of 2 to 1, it means that the visitor's inventory turned over twice in the reporting period.

Operating Margin = Income from Operations / Net Revenues

Operating margin is usually expressed equally a percentage. It shows, for each dollar of sales, what per centum was profit.

P/East Ratio = Price per share / Earnings per share

If a visitor'due south stock is selling at $xx per share and the company is earning $2 per share, then the company'southward P/E Ratio is 10 to 1. The visitor'due south stock is selling at 10 times its earnings.

Working Capital = Current Assets – Electric current Liabilities

• Debt-to-equity ratio compares a company's total debt to shareholders' equity. Both of these numbers tin can be found on a company's balance sheet. To calculate debt-to-equity ratio, you divide a visitor's full liabilities by its shareholder equity, or
• Inventory turnover ratio compares a company's cost of sales on its income statement with its boilerplate inventory balance for the period. To calculate the average inventory remainder for the period, look at the inventory numbers listed on the residual sheet. Accept the balance listed for the menstruation of the study and add it to the balance listed for the previous comparable catamenia, and then divide by two. (Call up that balance sheets are snapshots in time. Then the inventory remainder for the previous period is the offset rest for the current period, and the inventory balance for the current period is the catastrophe residue.) To summate the inventory turnover ratio, you divide a company's cost of sales (but beneath the internet revenues on the income statement) by the boilerplate inventory for the period, or
• Operating margin compares a visitor'south operating income to net revenues. Both of these numbers tin be constitute on a visitor'due south income statement. To calculate operating margin, yous split up a visitor's income from operations (before interest and income tax expenses) past its net revenues, or
• P/E ratio compares a company's common stock cost with its earnings per share. To summate a company's P/E ratio, you lot dissever a company's stock price by its earnings per share, or
• Working uppercase is the coin leftover if a company paid its current liabilities (that is, its debts due inside one-twelvemonth of the date of the rest sheet) from its current assets.

Bringing It All Together

Although this brochure discusses each financial statement separately, go along in mind that they are all related. The changes in assets and liabilities that you run across on the residual canvas are also reflected in the revenues and expenses that you lot come across on the income statement, which result in the visitor's gains or losses. Cash flows provide more data about cash assets listed on a balance canvas and are related, merely non equivalent, to net income shown on the income statement. And and then on. No one financial statement tells the complete story. Simply combined, they provide very powerful information for investors. And information is the investor's best tool when it comes to investing wisely.

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Source: https://www.sec.gov/reportspubs/investor-publications/investorpubsbegfinstmtguidehtm.html

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